The Burial of Keynes’s Effective Demand

[Effective demand] is the substance of the General Theory of Employment.
—J.M. Keynes, The General Theory of Employment,  Interest and Money (1936)

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It was of defining substance one day, yet disposable the next. “Effective demand” is part of the deep fabric of Keynes’s economics. Why was its life so short? What difference has this made? These are the questions I intend answering. Before doing so, I should note why this seemingly esoteric subject is fit for a general reader. First, an account of the matter is readily understandable; and second, it is important. The history of economic intervention by governments since the Second World War would have taken a quite different, more beneficial, course if effective demand had kept the starring role it was originally given by Keynes.

Those in academia carrying the torch for Keynes’s legacy are called post-Keynesians. Alone among economists they go back to Keynes’s defining work, The General Theory, for their inspiration. There they find effective demand. They extol the concept. They then become common-or-garden Keynesians, join the crowd, and give it no role at all in policy formation. This is unsurprising. From a policy perspective, it was killed off immediately after the publication of the book which brought it to transient notice. And, strange as it may seem, its demise was orchestrated by Keynes’s acolytes, and Keynes himself formed part of the burial party. Et tu Lord Keynes!

This essay appeared in a recent Quadrant.
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The definition of effective demand is inaccess­ible to those not attuned to the tortured language in The General Theory. You couldn’t get a cabinet minister to buy into it. However, when stripped down, it can be defined in quite straightforward terms. To wit: it’s the level of investment beyond which entrepreneurs, taken as a collective body, believe that further investment and its accompanying production and employment would be unprofitable. To continue the thread: if that level of investment and production is insufficient to employ all those willing to work at the going rate, then unemployment results. It’s as simple as that; and, to the point, is completely at odds with what is now known as Keynesian economics.

In the mid-1800s, John Stuart Mill rightly railed against those who attributed unemployment to insufficient demand. “Demand for commodities is not demand for labour,” he wrote. What employs labour “is the capital expended [that is, the investment] setting it to work”. Accordingly, while he might have baulked at the terminology, he would have found little amiss in the underlying concept of effective demand. And this tells you why it met its untimely end at the hands of early Keynesians.

Despite its appearance, don’t be fooled, effective demand is primarily a supply-side concept. Employment, it implies, is dependent on the preparedness of businesses to invest and produce. Accordingly, it is not at odds with Mill or with pre-Keynesian economics more generally. That simply wouldn’t do when Keynes, writing to George Bernard Shaw on New Year’s Day 1935, believed that his book would “largely revolutionize … the way the world thinks about its economic problems”.

Mill drew a causal line from businesses expending their capital to employment. Effective demand draws the same line. Let’s go to a desert island tale.

On this particular island the inhabitants rely on coconuts and berries for sustenance. The islanders would like to eat some fish but they need to get beyond a shoal to catch them. One enterprising islander gets some islanders to pick more coconuts and berries than they need and to hand them over for the promise of fish. He then uses the saved coconuts and berries (his capital) to employ and pay (in kind) a group of stout fellows to build and crew a boat. The boat built and fishing under way, he recompenses his backers and sells his surplus fish for coconuts and berries and various household services. Henceforth the islanders enjoy a varied diet of coconuts, berries and fish.

Where exactly is demand in this tale? Well, clearly the islanders desired fish. But this desire is inconsequential in itself. What produces fish is the decision of the enterprising islander to raise capital and use it to employ people to build and crew a boat. Mill and Keynes agree at this point. While loudly rejecting the economics of his predecessors, Keynes is simply dressing it in different clothes. Unfortunately, this is not the end of the story.

Keynes doesn’t stop with effective demand. He enjoins consumer spending in his theory of employment and talks of people consuming proportionately less of their income as they get richer. Accordingly, he thrusts us into a world where, if only people would consume more, employment would be greater.

The dyke is breached. Malthus and his fellow “underconsumptionists”, long since consigned to oblivion by Mill, are given fresh life. Though, to be clear, this is studiously unacknowledged. Keynesian economics must be seen to be saying something new rather than rehashing a discredited old theory.

Recidivism is endemic in economic life. Else why would communism keep on being tried? Error has a way of lurking in the shadows waiting for its opportunity for fresh respectability. If only the islanders desired (demanded) more fish, more crew would need to be employed, so the expert Keynesian economic adviser says. It’s an alluring story for the simple-minded. But, pray tell, how do the islanders get the wherewithal to pay for the extra fish? They must first produce something. Moreover, any decision to employ more crew in order to catch more fish will depend on whether the boat owner thinks it will be profitable. He is the central actor in this economic play. His investment and production decisions drive employment. Employment drives demand. That’s the way it works.

Keynesian economics puts the cart before the horse. As Richard Holt and Steven Pressman put it (in A New Guide to Post-Keynesian Economics, 2001): “For Keynes as for Post-Keynesians, it is demand that drives the overall economy.” And demand is demand. If there is insufficient private demand, why then, government demand can just as easily do the job.

I don’t believe that Keynes originally saw the demand side driving the economy. In fact, Joan Robinson, one of Keynes’s famous acolytes at Cambridge, reportedly said that Keynesian economics had to be explained to Keynes. This implied dichotomy between Keynes and the economics that bears his name is spelt out by leading post-Keynesian economist Lance Taylor (in Maynard’s Revenge: The Collapse of Free Market Macroeconomics, 2010): “Increase G, or if in doubt boost government spending, is the simplistic version of Keynes’s fiscal message. In fact he never said that. The idea was an invention of his mainstream followers.”

Of course, Keynes’s original “fiscal message”, whatever it was, doesn’t matter. He became a Keynesian and thus adopted and propagated “the simplistic version” of his fiscal message. As, by the way, does Taylor elsewhere in his book, despite his well-made epistemological insight:

By generating public demand for output by tax cuts and government spending at a time when private investment and consumption were contracting it [Obama’s stimulus package of 2009] gave enough support to income to rule out a very deep recession (or even depression).

Stimulus packages are the sine qua non of Keynesian economics as it is taught and practised. No one reads Keynes. Ask economists in government treasuries or in central banks to define effective demand and you would get blank looks. Or they might naively and mistakenly guess that it is just demand backed by money.

Imagine if they actually understood effective demand and, moreover, gave it the central role in economic affairs that Keynes ascribed to it in what he called his “General Theory of Employment”. But, of course, this would be nonsensical. Keynesian economics and the centrality of effective demand are mutually exclusive.

Effective demand leads policy-makers to ask quite different questions than does Keynesian economics. Keynesians look at the economy and visualise broad categories of undifferentiated consumption, investment and government expenditure. Listen to the way public-service economists describe economic growth. You will hear a lot about the sum total of these expenditures, which they call “domestic demand”.

Through this Keynesian theoretical prism unemployment can be remedied by increasing domestic demand; and any old demand will do. Thus, the blunt instrument of increased government expenditure on building roads or school halls and the like can supposedly encourage businesses to employ more people. For a time, it will help a narrow range of businesses: those directly benefiting from government largesse. For the rest, it will only tend to increase their material and labour costs. It is a remedy which interferes with market price and wage signals. It is therefore devoid of economic sense.

Effective demand focuses on the common need of all businesses to face fewer obstacles to their development and growth. It leads to supply-side solutions: to lessening product and labour market regulations, to creating a stable background of government activity, to lowering business taxes and, in times of stress, to lowering interest rates.

Mill expertly and rightly discarded the notion that the demand for commodities drives employment. Yet that very notion was recycled under the guise of Keynesian economics and became the dominant face of economic policy. The result has been misallocated resources, insipid recoveries and crippling public debt. Capitalism is resilient. Nevertheless, Western economies would have fared better, and would be in better shape now, if Keynes had not thought to revolutionise economics. Or, if those around him at Cambridge had not been minded to develop a Left-centric caricature of his economics.

Did Joan Robinson or, say, Sir John Hicks (one of the two famous economists who put simplistic Keynesianism into diagrammatic form) ever give due consideration to the import of effective demand? I don’t know. But, given the course of events, it seems doubtful. And, in any event, uninfluential.

Within a short space of time, Keynesian economics became the dominant face of macroeconomics. It became the “conventional wisdom”. Sceptics were marginalised, at least until Milton Friedman and monetarism gained ground in the 1970s. Even then, Keynesian economics overwhelmingly prevailed and led almost all Western governments into profligate spending in 2010 to combat the so-called Great Recession.

As J.K. Galbraith explained in The Affluent Society (1958), conventional wisdoms are extremely stubborn. They can be overturned only by confounding events. However, economies are such complex and dynamic systems that, whatever happens, it is possible to claim particular policies helped. Yes, the US economy limped along for seven years after Obama’s stimulus package. But, hey, the story goes, it would have been worse without it. And, so far as Paul Krugman is concerned, and other Keynesians like him, the problem stemmed from the stimulus package being too small. Nothing can be proved empirically.

Keynesian economics is also buttressed by a leftist political philosophy which says that capital­ism is flawed and must be augmented by government intervention. Unfortunately, leftism has been on the march through universities and the media. The Keynesian conventional wisdom is therefore nestled in safe hands. However, it would be mistaken, I think, to characterise the original emergence of Keynesianism as some dastardly leftist plot. That’s too conspiratorial.

The world of the middle 1930s badly needed an explanation for the Great Depression and a means of giving a degree of comfort that there would be no recurrence. Keynesian economics filled the need. It provided an easily understood explanation: private domestic demand can fall below the level required for full employment. And, also, a beguiling solution: increase government expenditure to make up for this shortage. How neat is that!

Dealing with real life is much messier. Exactly what should you do when thousands of businesses operating in different parts of the economy, producing tens of thousands of different products, face market circumstances which lead many of them to invest and produce less? When set against this complex reality, a quick fix of spending more government money, willy-nilly on this or that, is fatuous on its face. Yet it survives as the prevailing orthodoxy in textbooks, in academia, in the media and, most particularly, in government.

Keynesian economics is a theory for all seasons. Whatever happens after its prescription is administered, its curative powers are extolled. Keynes would not have become nearly so famous if effective demand had retained its defining role in his economics. Thus, effective demand had to go. Well, that is not completely right. As I have noted, academic post-Keynesians like Lance Taylor still pay heed to effective demand in theory. However, it is given no policy face. It’s a way of remaining chaste in thought but not in practice.

Peter Smith is a frequent contributor. He wrote the article “Robotic Reductio ad Absurdum” in the January-February issue